Research engine optimisation

Research reform starts here for Europe's investors

European regulators are leaving it to investors to figure out whether asset managers are wasting money on equity research. That is the kindest interpretation of the European Securities and Markets Authority (ESMA)'s proposal to unbundle trading and research costs, published on December 19. The snag is that few clients would have the sophistication to know whether this money is being spent well on their behalf.

ESMA's advice to the European Commission is mostly welcome. It suggests forcing asset managers to ring-fence budgets for research, and investment banks to price it explicitly. That will shine a light on a notoriously opaque market that has squished together charges for equity analysis with those for trade execution. Brokers have for years exploited the system by stretching the definition of research, thereby piling on costs for end-investors. Asset managers have been complicit by failing to track how they spend client money. Watchdogs, meanwhile, have been slow to crack down on questionable practices such as charging for face-time with company executives.

Fund managers and brokers alike will be cheered that the former can still pass on research costs to their own clients. The UK's Financial Conduct Authority had wanted to force investment firms to pay for research out of their own pockets. Though asset managers may in the future be inclined to spend more on in-house analysis, investment banks will presumably be able to avoid large-scale analyst redundancies.

One area that may attract wholesale market lobbying is the use of "commission sharing agreements," or CSAs. These are a way to allocate on a portion of a trading commission paid to one investment bank to third-party research providers, post-transaction. Their virtue is in preventing fund managers having to trade with a broker just to get its research. Brussels appears to think CSAs may add to costs in some cases by providing a cover for continued wasteful spending. But for now it's clear that CSAs have an important role to play in opening up this market.

Requiring research and trading budgets to be separate and transparent will help to instill a degree of discipline in the industry. It still leaves it to end-investors to assess the value of research, when fund managers might make better purchasing decisions if they footed the bill themselves. The proposals are an improvement on the status quo, but if they don't lead to changed behaviour, more radical reform will be needed.